The Laffer Curve: The Line Between Government Revenue and Economic Prosperity

>> Joshua D. Rauh: Okay, so, I'm gonna skip through a couple of things just cuz I wanna kinda go a little bit quickly, cuz I don't have that much time. But Piketty and Saez also suggest a connection between the amount of inequality we've seen and marginal tax rates. So this graph here shows, what's happened to the highest federal marginal tax rate over time.

It actually used to be, where the French economists would like it to be. The highest federal marginal tax rate used to be around, 95% now or 90%. And then it came down, in the 70s, early 80s, and now it's around, it's in the upper 30s. And they compare that with the wage income share for the top 1%, which has shown this u-shaped pattern.

So they found that when the marginal tax rates are low, income inequality is higher. And they draw a direct comparison between these two things. In fact, they say that when marginal tax rates are low, they argue that high-income people are incentivized to more aggressively. Bargain for higher wages, essentially to expropriate employees to achieve higher income.

I mean, the way you think about this is if you're working, and you're working in an environment where the income tax rates are low. These folks would say, well, yeah, that gives your boss a good incentive to steal the fruits of your own labor, right? So that's their very, it has a very sort of socialist kind of tone to it.

I think there is something to the correlation. The wage income share definitely has this U-shape, and the marginal tax has U-shape as well. The marginal tax rates no, very few people actually paid 90% taxes in 1960 because the tax code was very, very complicated and had a lot of loopholes in it.

So that you could avoid paying that level of tax. So there's something of a U-shaped tax, U-shaped pattern in average tax rates, but not as much. What I do think is going on here, is I think there is a labor supply of high-income individuals explanation going on here.

Meaning that, when tax rates are really high, and when the tax code is super complex, you don't necessarily really want to invest to start a business as much. You don't wanna do that, take on that extra job. If the government's gonna take a big chunk of your money, that really reduces your incentive to do that.

And so, we have this problem in economics called distortionary taxation. Going back to someone else from the French speaking world, Jean Baptiste Colbert. The art of taxation consists in plucking the goose, so as to procure the largest quantity of feathers, with the least possible amount of hissing. So, what he was referring to was the fact that when you try to tax something as the government, what's gonna happen?

Well, people are gonna do a little bit less of that in response. So, you might compare some types of taxation, a tax on just land, that won't really affect the amount available. So a lot of people, including Milton Friedman, have said that taxing land, is actually a pretty decent form of tax.

Or at least the least bad form of tax on the consumption of particular good or service is gonna lead to less supply of that. Although in some cases, that's intentional. For example, if you tax cigarettes because you want to address health issues and cigarettes that's an intentional desire to reduce, for better or for worse, the amount of purchase of tobacco.

Tax on income, well, if you tax it, you're gonna get less of it, and it's inherently a tax on productive behavior. So, when you tax income, you get less of it. And what are the implications if people respond by working less when you have higher taxes? Well, you're probably gonna have less provision of labor supply, you're gonna have less job creation, you're gonna have less investment.

And so, I think that might be what explains these correlations in these marginal tax rates with the income inequality. I think upper income people, based on my own research, are actually quite sensitive to tax rates in terms of the amount of investment that they do. A person who might be known to you, or maybe not, I don't know if they teach his work in introductory economics courses at universities very much anymore, is Art Laffer.

He came up with this point that there might be something called a Laffer curve, or a maximum point of the tax rate that would maximize revenue. Because once you increase the tax rate beyond that point, you're gonna reduce the amount of revenue that the government brings in. So, here's a stylized version of it, and here's the version that he sketched on his board, which I guess was flipped sideways.

But the idea is that there's some tax rate that maximizes revenue. You think about Cuba or some country that's basically taxing 90%, 95% income. People are just not gonna work, they're just not gonna have it. They're not gonna continue to produce the amount of income that they were producing if the government's just gonna take it all.

So, President Trump gave him the Presidential Medal of Honor. The New York Times, responded by saying, there's a dangerous folly of Lafferism out there. So there's a lot of controversy about Art Laffer. My view about the Laffer curve is, I mean, it's an interesting concept. The peak of the Laffer curve, is only optimal, I think, in a very narrow sense, which is the government revenue maximization with a single rate.

The French economists, they took the Laffer curve and they said, well, we actually have an answer. The top of the Laffer curve is around 80%. We think that's the rate that would maximize the amount of tax money that the government brings in. And I'm not sure that's the question we should be asking.

The question we might wanna be asking is, what's the tax system that maximizes the overall production and prosperity of the economy, with a tolerable amount of income inequality? We're balancing out these two things. It's the old trade off in economics between, on the one hand, prosperity and the other hand, inequality or equity.

So, Marty Feldstein found that an increase in the personal income tax rate involved a deadweight loss of $2 for every incremental dollar of increased revenue. Meaning that, when the government raises tax rates, people are gonna do less business investment, they're gonna work less. And a lot of that happens at the top, and the top contribute a lot of those tax revenues.

So, I've actually found in my work studying tax increases in California, that it's not only people leaving California when taxes increase. But it's also people staying and doing a lot less business investment. So, I think there's really some truth to that. So with high taxes you're gonna get, less income inequality, but you're also gonna get, a lot less prosperity.

I'm gonna skip over this. I wanna show, I think this is probably maybe one of the greatest moments in my view, recorded British parliamentary history. And I think it encapsulates, a lot about the debate, about income inequality. So have a listen.

>> Video Speaker 1: There is no doubt that the prime minister has in many ways, achieved substantial success.

There is one statistic, that I understand is not however challenging, and that is that over her 11 years, the gap between the richest 10%, and the poorest 10% in this country, has widened substantially. How can she say, at the end of her chapter of British politics, that she can justify many people in a constituency such as mine.

Being relatively much poorer, much less well housed, and much less well provided, than it was in 1979? Surely she accepts, that is not a record, that she or any prime minister, can be proud of.

>> Margaret Thatcher: Mister speaker, all levels of income are better off than they were in 1979.

But what the honourable member is saying, is that he were rather the poor were poorer provided the rich were less rich. That way you will never create the wealth for better social services as we have. And what a policy. Yes, he would rather have the poor poorer. The white is the rich were less rich.

That is a liberal policy.

>> Joshua D. Rauh: That was Margaret Thatcher's last day as prime minister of the united kingdom. It's hard to imagine someone going out with more of a bang than that, she said. She characterized his statement as you would rather. Have the poor poorer, so long as the rich do not get richer?

And it does raise the philosophical question of how much should we be paying attention to differences in how the real incomes have evolved over the different quintiles. I showed you a graph earlier that showed that over the quintiles, the bottom quintiles actually grown the most. But shouldn't we be happy if everyone is?

If growth there's growth across the income distribution, as long as it's not too unequal. So, last thing I want to say before I move to questions is, I think there is definitely valid truth to the idea that market income inequality has increased. Meaning that there has been an increase in the inequality among pre-tax earnings that reflects, I think, changes in the returns to skill, right?

So higher income people, pre-tax, there's been an increase. And where is that coming from? There are a few explanations. One could be changes in returns to education, one could be skill biased technological change. The technology has evolved in such a way as to provide greater returns to people who have a lot of skills.

I read a headline in the Wall Street Journal today that firms like Netflix and technology firms are hiring AI skilled people for $900,000 base starting salary. Okay, it sounds like skill bias, technological change. All of a sudden, this technology is hugely in demand, and there just aren't that many people who can do it.

There's been a decline in unionization and also some minimum wage spillover effects. That's another theory,and a globalization shock as well. We've had a lot of competition from other countries, so none of these can individually explain it. And I think the current state of research has not disentangled what's causing it.

But if you're concerned about income inequality and you wanna solve income inequality, as many of you, I'm sure, are and have that feeling, you've got to grapple with these forces. And I actually think one reason you want to address why we have this pretax income inequality is that all this redistribution that we're doing is actually quite costly, it's discouraging a lot of economic activity.

And it would be better if we could get to a set of tax rates that maybe were closer to what you actually said you wanted in your poll, but maybe with more of a balance in skills. Because all of these markets are determined by the supply and the demand for people supply of AI engineers versus demand for AI engineers.

Supply of people with a given skill versus demand for people given skill. And I think that's where we have to look if we wanna understand what's going on with income inequality. So that's my talk, income and wealth inequality receive a lot of attention from media and politicians, it's often overstated.

The US's tax and welfare system is already very progressive, it alleviates a lot of inequality. Further redistributive policy has a lot of problems and pitfalls that are disproportionate to the issue it's trying to solve. And I would urge you to focus your attention if you're interested in equality, on opportunity in the labor market.

Given the supply and demand for skills, as opposed to how can we continue to increase, do even more distortionary taxation, even more redistribution than what we've done already? I also wanna direct you a sort of shameless plug that we write about these issues a lot on my substack, libertylensecon.substack.com, so check that out if you want more.

>> Speaker 1: Okay, thanks, Josh, great talk, we have some questions now.

>> Joshua D. Rauh: Five minutes, yeah.

>> Audience 1: Hello, thank you for the presentation. So I have a question on the marginal value of money. So a $100 would be more valuable.

>> Joshua D. Rauh: Where are we over here? Sorry.

>> Audience 1: So a $100 will be more valued by a poor people than by a billionaire.

So how informative would it be if we only focus on the dollar value of income rather than how much, like how, how much people actually value that money?

>> Joshua D. Rauh: Okay, very good question, all right? So this is kind of, and there is an allusion to this in the reading as well.

When you apply a utility function, this is a maybe serve for economics majors, the utility function to a dollar amount of money. Most utility functions have the feature of being concave, meaning that the marginal utility of an additional dollar that you get is very, very high if it's the first dollar that you have.

And it's kinda low if it's sort of the millionth dollar that you have, so if I could re express what you're saying in those terms. And I guess my thing I would say that is actually the basis on which models of progressive taxation deliver these very, very high tax rates, is these very, very concave utility functions.

And I think if you look at what determines happiness, which might be the closest thing to utility, what we find is that it is true that for very low income, if you don't have anything, then that income support, that poverty support is very, very important. Once you get to a certain amount of money where you're essentially self sufficient, it really flattens out.

And so I think it looks pretty flat above a level where we're providing services for the indigent. And so I would then advocate for making sure that we have a robust set of services for the indigent, for the poor. But I'm not sure that these very concave utility functions are justified once we're comparing somebody who makes $80,000 versus 120 or 120 versus 200.

Well, those things have always been expensive, and they've been expensive since the beginning of time. And I think the question is, number one, has it gotten much worse? And number two, are we doing enough about it? And I think there definitely is a perception that those things have gotten more expensive.

We do have price indices that determine that show you exactly how much more expensive they have gotten. We provide a lot of government services for those things, I would say on aspects like housing, why is housing so expensive? Is housing so expensive because the government doesn't give people enough money to pay for their rent?

Or is housing expensive because the government is limiting the supply of housing in unreasonable ways? I think that's the question you have to grapple with on housing, healthcare. Why is healthcare so expensive? Is health care so expensive, because we don't have a very robust market, competitive market for healthcare, where you can compare the prices of your hip replacement at one doctor versus another.

Or is healthcare so expensive because the government is not giving you enough money to pay for your healthcare in all of these things? What I keep coming back to is that there's something wrong with these markets, usually, that the government is contributing to making a lot of those things more expensive.

>> Audience 2: Okay, thank you for that talk. I actually especially appreciated your analysis of what you characterize as the French Berkeley professors. I'm actually more interested in your thoughts on a different professor of inequality, perhaps, that you didn't mention, which is Raj Chetty, one of my at the Harvard economics department.

He teaches one of the most popular classes back in Cambridge. So I was wondering maybe your initial thoughts, reactions to his work, and particularly in his methods of big data and other, I guess, more empirical analysis.

>> Joshua D. Rauh: So all of these researchers, including Raj Chetty, use big data analytical techniques.

And I think Raj Chetty is doing it in a way where he's also using machine learning and other techniques to try to evaluate causality of different programs. Another distinguishing factor of Raj Chetty's work is that he studies a lot this question of mobility. People moving from the lower, being able to move up from the lower part of the income distribution to a higher part, or intergenerational mobility.

Do you move up in the income distribution relative to your parents. And he has documented something that I think is valid, which is that there has been a decline in absolute mobility, meaning that it is the case that today someone born into poverty is less likely to move far up income distribution relative to someone, say, 80 years ago.

The. The issue that you have to think about with that study and with those claims is, okay, why is that? It turns out that as societies become wealthier and enter later phases of economic development when they become richer, it simply is the case that there's less mobility. So would we like to go back to a state of economic development from the 1920s or the 1930s simply to say we have more mobility?

Kind of comes back to the fact that all levels of the income distribution are much better off than they were a while ago. So I think Professor Chetty's research on opportunity is very valuable, and I think what's needed often is some perspective on. I think that the media often sort of takes perspective on research that I think the researchers themselves might not even necessarily have.

I mean, I would say probably the french crew, I think, may seek out some media attention. I'm not sure Professor Chetty seeks out live media attention, but sometimes his work is interpreted by the media in various ways.

>> Audience 3: So in your argument about the time series, that flattened out inequality based on the researchers you were adjusting for, or I guess the government researchers were adjusting for demographic changes.

So poorer people having fewer kids or more people filing as dependents but those, to me, seem like, potentially very connected to income inequality or just inequality in general. So I guess if we're trying to solve inequality in general, how do you respond to those demographic changes, do you see that as causal or like any other direction?

>> Joshua D. Rauh: I think the government economists are doing two things number one, they are attempting to account for economies of scale within households. And number two, they're trying to account for the fact that there are more households with fewer people in them so they are trying to do both of those things.

So, to give an example, you can imagine one household where you have a married couple and they're earning $100,000 a year total because each is earning $50,000 a year, or two households where they're each earning $50,000 a year. And so maybe you're in a situation now where you're likely to have more of those granular households, they are also trying to measure in their numbers, using the best economic research that they can, what is the economy?

What are the economies of scale of being able to live in one house, for example. So that's a place where having that income together might be more valuable than having it granularly, so they are attempting to adjust for that and address that.

>> Audience 4: Hi, thank you for speaking with us, I was wondering if we're trying to solve wealth income inequality, if we're trying to balance this trade off between prosperity and equity.

Do you think it's necessary to agree on a consistent measure of the, of assessing inequality, are we thinking of proportionate amount, proportionate growth? Are we thinking of upward mobility being the same, if not better, over time and I think these are not mutually exclusive at all therefore, is it necessary to agree on the measure?

>> Joshua D. Rauh: I think it's necessary to want to be able to target, I think if we can't agree on some kind of measure and some kind of target, I'm not sure how we can actually make policy. We started the session by looking at what top 1% income inequality was under a certain definition.

If we want to change that definition or target a different definition, that's fine. So I do think it's important for policymaking to be able to say, what is the measure that we're going to look at of well being, we gonna look at income, we gonna look at wealth?

There are other measures of well being, consumption, happiness, I mentioned before, there are many measures of well being. What's the measure that we're going to target, and how are we going to evaluate the success of our policies? Because we have to also, if we're going to make policies, we got to be able to have some way of assessing whether they worked or not.

So I do think coming to some conclusion about, some conclusion about how to measure inequality is important.

>> Audience 5: All right, once again, thank you so much for your talk here, it was very informative. The main aspect of your presentation that interests me is the labor market and its future.

So I know this is a buzzword here, but artificial intelligence is definitely going to be changing not only federal government operations but I would assume operations in the private sector. A lot of, I guess you could say, lower tier jobs, I suppose, accounting, a lot of office work is going to be taken over, presumably by artificial intelligence, which I can only assume would adversely affect the supply and demand for skills in the public and private sector.

My question for you is, is there any historical precedent you would point to with regards to how technological innovation affects inequality and opportunity in the labor market? And can we use that to learn about how artificial intelligence will affect revenue going forward in the next decade?

>> Joshua D. Rauh: I think if we look at history and the series of technological innovations that we've seen over the last few hundred years, usually there is a.

Exactly the phenomenon that you describe is the first thing that people jump to, okay. The cotton gin is going to destroy the livelihood of people who were doing that work manually or we can go back even further. The printing press is going to destroy the livelihood of the scribes, okay?

Everything, the computer is going to destroy typists and people who are calculating things by hand or using calculators. The Internet is going to destroy local people are trying to sell things locally in stores because you're going to have companies like ecommerce, companies like Amazon and so on. And yet, to some extent, all those things came true because people who were in those displaced professions they were seriously affected by this, by these technological revolutions.

However, all of them, all of them have led to much greater prosperity over the medium term and long term, at all levels of income. And so I think what we learned from the history of economics is that with something like AI as well, it's going to create major dislocations in the labor market.

And we probably want to focus on what the right way is to make sure that there are opportunities in the labor market for people to reskill or upskill if they've been affected by the coming of AI, just like with any new technology. I think that's very, very important but I do think that we should not fear technological innovation as something that's going to increase in equality and for that reason, we shouldn't do it, because ultimately in the long run, it does lead to more prosperity.

And we have to think about what the right way is to smooth over those transitions.